Investment Update


Investment Update - Ivy Value Fund

Commentary as of August 26, 2020

Typically when coming out of a recession, one would expect value and small caps to outperform in the subsequent rally. So far, small caps have led the way, but value is still lagging. Why do you think the rally is different this time for value, and what do you think it would take for value (measured by the Russell 1000 Value Index) to have a more sustainable run versus growth (measured by the Russell 1000 Growth index)?

We don’t think that it’s different this time around, it has just been delayed. We foresee value performing better than growth for about six to 18 months, but we don’t really know when it will start. We think of this less as value versus growth companies and more as cyclical versus stable companies. A lot of stable stocks have high price-to-earnings (P/E) ratios and therefore end up in the growth index even if they’re not great growers. You have Microsoft and Amazon, which are considered growth stocks, but then you have Procter & Gamble and Coca-Cola, which are not particularly fast-growing stocks. When COVID-19 hit and the economy shut down, these companies were relatively unaffected. Growth stocks have generally done fine and many have actually benefitted from a working from home environment.

When you take a look on the cyclical side, the majority of cyclicals end up in the value index. These stocks need a strong U.S. economy to work. When the pandemic began, airline traffic was down 99% overnight. Hotels, casinos, credit card companies, financials and restaurants were also hit particularly hard. The Fund owns Capital One, which started the year at $110 with earnings per share (EPS) estimates at about $11.50, and the stock is now at around $60 with earnings at about -$2 EPS.

At some point in the future, we believe this pandemic nightmare will end and we will eventually go back to normal. We know Pfizer plans to submit its vaccine for regulatory approvals in October, and we hope all goes according to plan. If not Pfizer, we think some other company’s vaccine will probably get approved in the next six to 12 months. Once this happens, airlines, credit card companies and casinos should get back up and running to around pre-pandemic earnings levels.

Another point that we’d like to make is that value doing well doesn’t necessarily mean that growth has to perform poorly. Microsoft and Procter & Gamble weren’t overly impacted when the U.S. economy shut down and these companies shouldn’t experience a major boost when the economy fully reopens. These stable types of companies could be a little weak if investors try to sell them to shift to more cyclical names, but we don't foresee this happening. We think there are many areas in the value index that need to recover first then we expect to eventually see a nice tailwind.

The last time we had you on one of these calls back in April, you had mentioned that situations like the March drawdown can present opportunities to purchase stocks at significant discounts relative to their intrinsic values. Obviously, we haven't seen any additional dips quite like the March; however, volatility has remained. Have there been many of these types of opportunities over the last three to four months?

There haven't been as many opportunities as there were in the drawdown. As the cyclicals were falling rapidly in March, many of these stocks got down to prices where we started to nibble. Of course, we don't know where the bottom of the market will be, so nearly every day we were making small purchases throughout April. Today, we believe the market is in a little bit more of a normal environment. Value has recovered but not nearly as much as we think it could.

There are a lot more individual opportunities we’re seeing now. For example, Evergy is a utility company in Kansas City that everyone thought was going to get acquired, so the stock went up to around $65 per share. Once the news came out that the company wasn’t going to get bought out, the stock dropped down to around $50 per share. We entered this position because we think the intrinsic value is at least $60 per share and will come back once the “hate selling” is over.

We’re also keeping our eye on a lot of insurance companies. We’re about to have a hurricane hit in Louisiana and Texas. It’s very common for insurance stocks to get hit because investors are concerned of the potential losses. History will tell us that it could be a great time to buy them.

We purchased Las Vegas Sands because the stock was overly priced at around $55 per share because investors thought that Macau was going to open up. When Macau officials announced that they weren't quite ready to reopen, we felt the stock was unfairly punished when it went down to around $42 per share.

In the drawdown we lagged the Russell 1000 Value index, the Fund’s benchmark, then performed better than the index in the subsequent rally by the end July. Do you think the strategy’s performance so far in 2020 aligns with your performance expectations?

Historically, the strategy has had a beta higher than one (meaning the strategy has been a bit more volatile than the market), and that has been a function of two things. First, we want to be active investors with high active share and not hold a lot of cash. As value investors, we own a lot of the cyclical stocks that we previous discussed. These stocks tend to go down more than the market in down times and up more than the market in up times. We also hold the long-term belief that the market will go up more than it goes down over time.

In addition to the Ivy Value Fund you’ve managed for the past 17 years, you also manage the Ivy Focused Value Separately Managed Account (SMA). For those unaware, what are the key differences in the way you manage these two products?

The Ivy Focused Value SMA is noticeably different and that was intentional in creating the product because we wanted something that was differentiated from the Fund. The SMA is non-diversified and has a much greater focus on dividends. To determine holdings, we start the process with a quantitative screen where we look for stocks in the 2nd quintile of dividend yield. Historically, the first quintile has shown to not be a good investment, but the second quintile has the best risk-adjusted returns. After that, we look for a low valuation, a low payout ratio and high quality based on a high return on invested capital (ROIC). Analysis of these screens will take us down to about 60 names. We then apply our fundamental, bottom-up research to reduce the portfolio to 25 names. The portfolio will be as close as we can get to sector neutral. With the portfolio being non-diversified, we typically expect the top five holdings to make up 30-35% of its weighting.

There has been comparison of this market environment to the environment we saw in 2000 where some value funds let us down because of style drift (the divergence of a fund from its investment style). What are you doing to avoid style drift, and has your definition of value changed at all?

Our definition of value hasn’t changed. We still look for companies that are trading at a significant discount relative to their intrinsic value. There’s certainly some style drift within our universe, where you could see a manager owning a handful of growthier stocks like Amazon to help performance. We believe a key reason that investors have interest in our strategy is because of the 35-45 stocks we own. These are all truly value names. Sometimes that benefits the portfolio, and sometimes it doesn’t. We don’t believe in managing a closet-value strategy for short-sighted performance benefits because that’s generally not what our clients hire us for.

Are there any industries that you are avoiding that currently are cheap, but you feel that their cheapness is justified?

We’ve never been big believers in the energy sector. We generally hold an underweight position in the sector. On a price-to-book basis, energy stocks may look cheap, but we look at free cash flow. Energy companies don’t typically produce much free cash flow but maybe only once out of every five years, which doesn’t fit our criteria.

Another space we are notably underweight is in real estate investment trusts (REITs). Office properties are cheap right now because we think a lot of investors believe the current working from home environment has legs that could keep more employees at home for the long term. Shopping malls are also cheap because many of them are failing. The simplest way to describe our process is in three steps. First, is the stock cheap relative to its normalized free cash flow? Second, if it is cheap, why is it cheap? Third, will the problem ever get fixed? With REITs, we don’t have the conviction regarding whether or not their issues will get fixed.

What's your thought on Walmart and e-commerce? If a vaccine for COVID-19 is ready and available, do you see e-commerce continuing to grow at its current rate?

In retail, we own Target, Walmart and Lowe’s. All of these stocks are doing better now with their e-commerce efforts than they have in the recent past. It always surprises us how Amazon has been outperforming these names for years. Walmart makes more free cash flow in a day than Amazon does in a month, and Walmart’s management didn’t know where to spend it. Finally, Walmart realized it needed to spend money on e-commerce. Its website, delivery and fulfilment have all improved. This was something we saw happen not only Walmart but also at Target and Lowe’s. We expect e-commerce to continue to grow. Yes, there was an unusual boost because of the COVID-19 pandemic; however, we still think this will be an upward trend and e-commerce will continue to gain share.

Past performance is no guarantee of future results.This information is not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through Aug. 26, 2020, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This information is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon.

Top 10 holdings (%) as of 06/30/2020: Walmart, Inc. 3.8, Citigroup, Inc. 3.7, Philip Morris International, Inc. 3.5, Comcast Corp. 3.5, CVS Health Corp. 3.4, Fidelity National Information Services, Inc. 3.1, Lam Research Corp. 3.1, Eaton Corp. Plc. 2.9, McKesson Corp. 2.9 and Broadcom, Inc. 2.8.

The Russell 1000 Growth Index measures the performance of the large-cap growth segment of the U.S. equity universe. The Russell 1000 Value Index is an unmanaged index comprised of securities that represent the large-cap sector of the stock market. It is not possible to invest directly in an index.

Risk Factors: The value of the Fund's shares will change, and you could lose money on your investment. The value of a security believed by the Fund’s manager to be undervalued may never reach what the manager believes to be its full value, or such security’s value may decrease. Investing in companies in anticipation of a catalyst carries the risk that certain of such catalysts may not happen or the market may react differently than expected to such catalysts, in which case the Fund may experience losses. The securities of many companies may have significant exposure to foreign markets as a result of the company’s operations, products or services in those foreign markets. As a result, a company’s domicile and/or the markets in which the company’s securities trade may not be fully reflective of its sources of revenue. Such securities would be subject to some of the same risks as an investment in foreign securities, including the risk that political and economic events unique to a country or region will adversely affect those markets in which the company’s products or services are sold. Not all funds or fund classes may be offered at all broker/dealers. An investment in the Fund is not a bank deposit and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. These and other risks are more fully described in the Fund's prospectus.

The impact of COVID-19, and other infectious illness outbreaks that may arise in the future, could adversely affect the economies of many nations or the entire global economy, individual issuers and capital markets in ways that cannot necessarily be foreseen. The duration of the COVID-19 outbreak and its effects cannot be determined with certainty.